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The Sweet Spot of
Concentration
OCTOBER 2016
A
cademic theory1 suggests between 25 to 30 holdings provide
optimal diversity in a single-market portfolio, but for Newton
Investment Management’s Raj Shant, finding the perfect balance can
be as much an art as a science.
For most investors the question of
risk adjusted returns,” he argues. “But
how much diversification is too much
if you go too far and have too many
is a crucial one. Too few holdings
stocks you begin to look more and
and you run the risk of your portfolio
more like the market, the benefits of
becoming overbalanced in favor of
diversification diminish and at that
just a handful of favorites; too many
point you shouldn’t be charging active
and the portfolio loses focus.
fees. It’s a balancing act that requires
On this point, the economist John
constant attention.”
Maynard Keynes put it best. “To
1. University of Technology Sydney:
“Diversification versus Concentration… And
the Winner is?” September 1, 2012.
2. The “Uncertain” Foundations of Post
Keynesian Economics: Essays in Exploration,
Stephen Dunn.
carry one’s eggs in a great number of
STRIKING A BALANCE
baskets,” he wrote, “without having
Academic theory offers differing
time or opportunity to discover how
views on the question of portfolio
many have holes in the bottom, is
concentration. In 1952, in Modern
the surest way of increasing risk and
Portfolio Theory, Harry Markowitz
loss.”2
outlined the concept of an “efficient
For Newton Global Equities Manager
frontier”—an optimal portfolio
Raj Shant, the question of when
that achieves the perfect balance
and by how much to concentrate
between risk and return. Since then,
portfolio holdings goes right to the
economists and investors have been
heart of successful active investment
split between the concentrators and
management. It’s a decision, he
the diversifiers. For some, such as
says, that can make or break returns
investment guru William J. Bernstein,
over the long term. “Up to a point,
an investor with even 100 stocks will
increased diversification offers better
not be able to eliminate unsystematic
Not FDIC-insured. Not Bank-guaranteed. May lose value.
risk. Likewise, in Modern Portfolio
holdings. In reality, though, according
Theory And Investment Analysis
to the Chartered Insurance Institute
(1981), Edwin J. Elton and Martin
(CII), most unit trusts have a pool of
J. Gruber argue a portfolio with 20
between 50 and 100 shareholdings.
stocks should offer the best balance
of risk and reward. For Warren Buffet:
“Wide diversification is only required
when investors do not understand
what they are doing.”3
The theory behind this is clear: since
different types of assets change in
value in opposite or different ways
it can make sense to spread your
investments over a broad range of
Nonetheless—and putting academic
asset classes and holdings. It’s an
theory to one side—diversification
approach summed up by the old
remains the dominant orthodoxy of
adage of not putting all your eggs in
current markets: a 2008 U.S. study
one basket.
showed the average mutual fund
had 90 stocks in its portfolio, while
DIVERSIFICATION: A DOUBLE-EDGED
the 20% of fund managers with the
SWORD
most diversified portfolios owned an
But for Newton’s Shant, this ignores
average of 228 stocks.4
a key truth: beyond a certain point,
Regulators have also taken the
diversification will begin to work
diversification mantra to heart.
against you: “A popular view is that
The U.S. Employee Retirement
increasing diversification reduces risk
Income Security Act (“ERISA”), for
but, in fact, the exact opposite is true.
example, which was signed into law
in 1974 and which regulates the
administration of retirement and
benefit plans, has a “diversification
rule”. This rule requires fiduciaries
to diversify investments to minimize
any risk of loss unless it would be
considered prudent not to do so. In
Europe, likewise, the UCIT so-called
5/10/40 rule says a maximum of
10% of a fund’s net assets may be
invested in securities from a single
3. Financial Times: “Concentration: the case
for putting all your eggs in one basket”,
September 29, 2013.
4. Financial Times: “Too many stocks spoil the
portfolio”, April 12, 2013; Eastern Finance
Association: “Do Focused Funds Offer Superior
Performance?” March 2008.
2
issuer and that investments of more
The larger the number of holdings
you have, the harder it is to know
all the risks associated with every
single one of those holdings with
absolute certainty all of the time—
and that’s the case even in a relatively
concentrated portfolio. If you hold,
say, 100 stocks, the chances are you’ll
know that hundredth stock far less
well than you do the first stock in the
portfolio. The more diversified the
portfolio, the more those unknown
and unknowable risks increase.
than 5% with a single issuer may
“As you extend the tail of stocks you
not make up more than 40% of the
know less well, the greater the risk
whole portfolio. In effect, this means
that one of these less known holdings
funds must have a minimum of 16
will perform badly and act as a drag
on your performance. In this sense,
unexpected risks turned round to bite
diversification can lead you into
investors.
unknown and unintentional areas of
risk. It’s a double-edged sword.”
“As you concentrate your portfolio down
to fewer and fewer holdings, everything
In addition, a thinly spread portfolio
ends up riding on how just that handful
also means a lower level of conviction
of stocks is performing. If things go well,
in any individual holding. Says Shant,
great; but if they go wrong they could go
“With a highly diversified portfolio, the
very wrong and your performance will
average size of your position in each
suffer as a result.”
holding will decline so that even your
best ideas get diluted. Even if a single
holding performs extremely well, the
benefit of that for your portfolio and
your clients is diminished.”
WHEN CONCENTRATION HURTS
But what about the risks of an overly
concentrated portfolio? Here, too,
Shant highlights the danger of going
too far towards the opposite end of
the spectrum. One problem, he says,
For Shant, while theories of optimal
portfolio construction are important,
in the real world they can be difficult
to pin down. For now, while he
believes a portfolio of between 30
to 50 stocks in a globally invested
portfolio can provide the optimal
balance between concentration and
diversification, the basics of fund
management are equally important.
“Ultimately, regardless of whether you
is liquidity. In a highly concentrated
have a highly concentrated portfolio
portfolio, the ownership stake in each
or a highly diversified one, nothing can
firm will be larger and the harder it
replace the fundamental importance
will be to move in or out of that stock
of thorough research, really
without impacting pricing and affecting
understanding a company and really
the overall performance of the fund.
believing in a company’s management
Another issue is elevated risk.
team.”
The higher your ownership of any
Here, Shant’s view aligns with Keynes.
one company, the greater the risk
In a letter to Francis Scott, Chairman
associated with that holding. Says
of the Provincial Insurance Company,
Shant: “Even with the best will in the
the English economist wrote: “As
world you cannot identify every single
time goes on I get more and more
risk associated with every single
convinced that the right method in
company. The history of investing is
investment is to put fairly large sums
littered with the carcasses of formerly
into enterprise which one thinks one
well respected blue chip companies—
knows something about and in the
the likes of Enron or Volkswagen,
management of which one thoroughly
for example—where hidden and
believes.”5
5. Letter to Francis Scott, Chairman, Provincial
Insurance (1934).
3
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communication and subject to change. This material has been distributed for informational purposes only and should not be construed as investment
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